In the last week, world equity markets, as measured by the MSCI World Index, have dipped back into “correction” territory with the benchmark in question having fallen back below the -10% mark (at the time of writing -11.24% in USD terms) from its September peak.
The sell-off across risk assets has been variously attributed to a cocktail of factors: the ongoing Sino / US trade hostilities, slowing Chinese economic activity, the likely pace of future US interest rate increases, the forthcoming cessation of the European Central Bank’s asset purchase programme and the Italian government’s attempts to push the EU budget restrictions to the limit and, of course, Brexit. All of these in isolation clearly have the potential to disrupt the status quo and/or negatively affect the global economy in a small way, but when aggregated, that impact is materially greater.
While the root causes of this latest risk-off episode are not difficult to identify, the catalyst for such an abrupt change in investor sentiment is far less obvious; after all, none of the factors we’ve highlighted can be described as new news – indeed, all have been present for some considerable time. Either way, the markets’ transition from “glass half full” into “glass half empty” mode, with fears of a global recession to the fore, has manifested itself in two main ways.
Within the equity space, media coverage of the sell-off has, at times, been dominated by the headline-grabbing reversal in momentum among the US internet (“FAANGs”) stocks that had previously dominated on the upside. In fact, the market action, in terms of sector movements, has been entirely consistent with a global “growth scare”: Energy, Materials, Industrials and Financials have suffered most among the 11 main industry categorisations, while Utilities, Real Estate and Consumer Staples are the top performers.
For bond market investors, the main focus of attention has been the changing shape of the US Treasury yield curve.
Here, thanks to a steady rise in short term rates, coupled with relatively stable (and most recently declining) long rates, the shrinking yield differential between 2-year and 10-year Treasuries from a peak of 78 basis points as recently as February to 15bps at the time of writing is also indicative of diminishing growth expectations. With many commentators extrapolating this trend to the point at which this yield spread goes negative in the near future, much is being made of the predictive power of this inversion as a signal of impending recession. In fact, it isn’t as reliable as many would have us believe: for example, since 1976 the US has experienced 5 recessions, whereas the 2yr / 10yr spread has gone negative on 11 occasions (i.e. a 45% hit rate).
The recent softening in some economic indicators means that there’s an element of logic to the market’s movements, it is also worth noting that there is plenty of data supporting a more positive outlook. Employment numbers in the US remain sound, with little evidence of a slowdown in the rate of new job creation, which averages a healthy 204,000 per month YTD, or a significant increase in the current unemployment rate of 3.7%. Likewise, Purchasing Managers’ Indices for the manufacturing and service sectors are both, at 55.3 and 54.7 respectively – meaningfully above the threshold of 50 that represents the divide between expansion and contraction. The Index of 10 leading indicators remains on a positive trend, as does business optimism.
As pragmatists, we are not blind to the possibility of a meaningful economic downturn and continue to monitor data, events and the views of the managers through whom we invest for any such signs. Importantly, even if we have seen a peak in the global economic cycle (which is entirely possible), it is still difficult to foresee a scenario in which conditions deteriorate quickly enough to justify the bearish outlook that markets are currently discounting. For the time being, therefore, we are maintaining our tactical risk score at a neutral 5 out of 10, based on the view that the downturn we have seen has been driven by sentiment rather than fundamentals.